Kotok: Russia Face-Off A Boon For XLE

In the midst of possible war in Eastern Europe lurks an opportunity for investors, Kotok says.

This article is part of a regular series of thought leadership pieces from some of the more influential ETFstrategists in the money management industry. Today’s article features David Kotok, chairman and chief investment officer of Sarasota, Fla.-based Cumberland Advisors.

Fast-moving events in Ukraine point to a bifurcation of the country—and a clear opportunity for investors.

The crisis is unsettling to be sure, but we believe it presents clear opportunities to invest in energy through such funds as the Energy Select Sector SPDR Fund (XLE | A-94) as well as through master limited partnerships (MLPs) focused on energy.

But before I get into that further, let’s look a bit more closely at what’s going on in Eastern Europe.

First, it seems clear that Russia will take control of the Autonomous Republic of Crimea, and that Russian influence will likely dominate the eastern side of Ukraine where the Russian language is spoken and the majority of the population is sympathetic with Russia.

That will leave Western Ukraine, and a divided country.

U.S. sanctions and rhetoric will have some, but not major, impact.

Mr. Putin will decide this outcome. European Union weakness and consequent reluctance to act will be confirmed. For an interesting discussion on Ukraine, see Foreign Policy Research Institute brief.

The issue to be determined is whether this division of the country will be accompanied by major military activity that could lead to a regional war.

If it is, contagion risk rises. If the situation does not erupt into an extensive military engagement, Ukraine-related events will be contained within the geographical area. For Cumberland, our base case is that there will be no contagion.

So, investors now have to determine what actions to take.

Last week, major markets ignored the situation based on the assumption that it will be contained. The U.S. stock market reached a new high on the last day of February in the midst of the evolution of events.

But that changed over the weekend, and, on Monday, markets—led by a pullback of as much as 10 percent for Russian equities—fell around the world.

So, if Cumberland is right, and this doesn’t turn into a regional war, where is the clearest opportunity for investors?

XLE And Beyond

One sector can benefit from events, and we believe that sector is energy.

The outcome of this Central Europe upheaval will add to pricing pressures or diminish downward pricing pressures on energy in some parts of the world.

The use of natural gas and other energy sources is a critical element in Russian strategy. The possible release of some oil from the U.S. strategic reserve may have a temporary impact.

President Obama has authority to release oil from the reserve since it is now holding more than the 90-day required amount. The reason the reserve is higher is that the U.S. has reduced its oil imports and the reserve is sized under a law that was passed when imports were higher. The reserve is currently 100 percent full.

Cumberland has already taken its position in the energy sector to overweight. We have used a number of exchange-traded funds in the U.S. market to gain that position. So far, that strategy has worked.

Specifically, as I said, we like XLE. We also like funds that focus on energy exploration and on oil and gas service ETFs, such as the iShares U.S. Oil Equipment & Services ETF (IEZ | A-79) and also the Market Vectors Oil Services ETF (OIH | A-59).